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Capital markets are a discount system and the current bear market is preparing us for slower economic growth due to a number of economic factors. But could slower growth, or even a slight contraction, be beneficial for the stock and bond markets? What can an investor do in this economic situation, when equities and bonds are moving in line, while the Central Banks raise interest rates and return to “quantitative easing” to control inflation? Bonds usually move in the opposite direction to stocks, but how should one think about their portfolio when they move in line?
How did we get here?
The years following the global financial crisis have proved to be unique. For the first time, non-Japanese central banks, which had done so before, intervened directly in the capital market by buying securities according to their Quantitative Easing (QE) plans. Despite this, the economic recovery in many countries had been rather weak and markets had become dependent on easy money. As a result, the Central Banks maintained historically low interest rates and raised their asset purchase plans. Milton Friedman would have expected all this liquidity to cause inflation. It did, but instead of higher prices of goods and services found its liquidity in the capital markets and real estate. This caused prices to rise sharply, leading to the longest cattle market in history.
Prior to the QE period, equities and bonds acted as balances in the portfolio. Shares rose in price as the economy and corporate performance improved. Bonds moved in the opposite direction. Despite low interest rates, inflation was broadly in line with (or below) targets. However, as inflation expectations rose, which led to higher yields, there was a risk that the economy would slow down, as is usually the case with higher interest rates. But QE severed ties as central banks bought more fixed assets and lowered yields. Not only does money facilitate but the merging of factors, including government subsidies, Covid19 supply chain problems, under the investment of many commodity stocks and finally the war in Ukraine has pushed inflation to a level not seen for decades in many developed countries. Finally, the Central Banks are responding by raising interest rates to keep inflation in check, but the world economy has already begun to slow down.
Most would argue that the US Federal Reserve has done too little, too late, even after the recent 75 basis point rise, and inflation is now uncontrollable. Others argue that the Fed is doing too much too fast and will cause a major recession. We believe that the Central Bank is richer in experience and more knowledgeable than many might believe, and most likely to respond to the data in the right way. Most investors use the Federal Reserve’s target interest rate to judge the central bank’s. On the other hand, as we have mentioned, markets are discount systems and the central bank has worked tirelessly to market participants’ interest rate expectations by guiding them upwards.
This can be seen in the sharp rise in yields, mainly in the short to medium term, as the yield curve. Only a hint of, or a slight hint of, future rate hikes is enough for investors to adjust their expectations and they have risen considerably. The Central Bank can (and does) increase market yields, in effect tightening monetary policy, without raising the funds’ short-term interest rates to the same extent. You can see in the chart above that the 2-year yield on the Treasury rose from 0.25% to 1.5% in February 2022 without the Fed actually raising interest rates, which now brings us to inflation expectations.
“Bad” news for the economy can be “good” news for the market
During the Covid-19 pandemic, the government effectively shut down its economies (ie supply chains, industrial production, multiple services, and parallel consumption), while at the same time generously supporting households and businesses with stimuli (monetary checks and fiscal concessions). and low interest rates and QE on the monetary side). As a result, consumers spent less, retailers froze their orders as inventory expanded and manufacturers closed factories or stopped production due to Covid restrictions. When economies reopened, the turnaround was large and rapid, leading to increased demand mainly for goods (less for services). As we expected, when one blocks supply and demand comes back by the power of inflation. It will be interesting to see in the coming months how the increase in retail inventory (as a result of retailers expanding / overloading inventory due to supply concerns) could lead to deflationary pressures as they release supplies in a slow-moving economy.
The Central Bank argued that it would not be possible to solve the bottleneck in the supply chain by raising interest rates, and “Inflation is temporary” became the message. They recently changed course with a continuous increase, including a 75-point increase in June, which is the highest since 1994, and more can be expected. “Expected” is the key phrase in the sentence.
The Central Bank now seems to be afraid of inflation and may be doing too much, but too late, which is why all positive (lower) inflation expectations can cause markets to rise. Furthermore, bad news about retail and consumer confidence, rising stocks and discouraging macroeconomic information may be good news for investors because the Fed will not be forced to be as aggressive in its rate hikes as the market now expects.
More supply + slower demand + rising stocks = lower inflation?
Retail giants posted revenue in the first quarter of 2022, focusing on increased inventory, especially in uncontrollable shares, and slowing sales. As a result, there was a significant loss in share prices in consumer / choice product categories. However, a combination of cooling retail, rising inventories and record high production orders offers an interesting movement that could help reduce inflationary pressures.
Consumer purchasing power is declining because wages are not growing as fast as inflation. However, US consumers increased their savings during the pandemic and now sit on billions of US dollars of surplus savings. Sensible consumers would cover their unmanageable expenses with their savings (if necessary) and delay the optional purchase of durable goods, luxury goods and homes, as we have recently begun to see.
Rising inventories among retailers, along with high orders and declining sales should lead to discounts, fewer orders in the future, lower production, lower commodity prices, and so on. This trend tends to reduce inflation without the Fed raising interest rates to an awkward level. Excluding general merchandise stores, inventory / sales ratios are still low in the retail and manufacturing sectors but appear to be rising. We expect the profits of the 2F retail sector to shed more light on the matter and we are following it with great interest.
The S&P 500 has now fallen by 20% since its historic high in January. Normally, its forward P / E ratio appears to be more attractive compared to 2021. The same applies to most major international indices, which are now below the historical average P / E ratio. Despite recent analysts’ declines in profits, we believe the current bear market has created a plethora of opportunities.
The recession is not certain
The Central Bank raised interest rates in the 1980s and 1990s to keep inflation in check without causing a contraction. Similarly, the bear market is not always a warning sign of a recession. The Covid era was full of extravagant valuations, overnight cryptocurrency / NFT millionaires and ample liquidity. Slowly and sharply, liquidity is being reduced from the financial system and valuations are returning to normal (if not discounted) levels. We doubt if anyone can call the market bottom, but for the long-term investor, stocks, and in some cases bonds, are much more attractive. As many times mentioned, including our company, it is the time in the market that is most important for your long-term return, not the timing of the market. We recommend adding risky assets to significant deductions if your excess liquidity allows, but not selling into the deduction at all.
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Recession is the buzzword
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